The EconomistFebruary 3rd 2018 59For daily analysis and debate on economics, visit
Economist.com/economics1R
ETAIL investors tend to dream of find-
ing a wonder stock—a Netflix or Apple
that will multiply their savings many times
over. But institutional investors cannot
commit too much capital to one individual
company. Instead, they hope to pick the
right kind of stocks, a broadly based group
that will beat the market.
Two or three decades ago, fund manag-
ers would have attempted this feat by fa-
vouring one industry overanother. They
might, say, have bought energy stocks in
the hope that the oil price would rise,
while avoiding retailers because of fears
about consumer spending. But in these
days of computers and algorithms, there
are more systematic approaches to beating
the market. The aim is to find stocks with
characteristics or “factors” that make them
outperform. In the industry jargon, funds
tracking these factors are known as “smart
beta”. The money allocated to smart-beta
exchange-traded funds has reached
$658bn; all told, more than $1trn is invested
in an explicitly factor-based fashion.
Definitions vary, but there are four or
five long-established factors that seem to
make shares perform differently from the
rest of the market: size, value, yield, low vo-
latility and momentum. The first of these is
based on the fact that small companies
have tended to outperform large ones.
“Value” refers to companies that look
cheap relative to their assets, which have
tended to beat those that look expensive.
“Yield” means shares with a high dividendalies that appear to work, to entice money
from clients. Run enough data tests, and
some strategies will appear to outperform.
A paper by Kewei Hou and Lu Zhang of
Ohio State University and Chen Xue of the
University of Cincinnati found 447 stock-
market anomalies in the academic litera-
ture. Their attempt to replicate the findings
showed that nearly two-thirds lacked sta-
tistical significance; on a more conserva-
tive approach, the failure rate rises to 85%.
Still, the best-known factors have been
too successful for too long for it to be a sta-
tistical quirk. Broadly, there are two possi-
ble explanations. One is that higher re-
turns compensate forsome form of risk.
Smaller stocks are less liquid and more ex-
pensive to manage, for example. Value
stockslook cheap because the firms’ busi-
nesses genuinely are more risky. Though
they believe in efficient markets, with noyield, which do better than those with a
low yield (though that maybe justanother
version of the value effect). “Low volatil-
ity” means those shares that move less
violently than the overall market, which
also tend to perform better than the aver-
age. Finally, “momentum” seeks to profit
from the observation that shares which
have risen in the past continue to do so.
Research by Elroy Dimson, Paul Marsh
and Mike Staunton of the London Business
School has shown that these factors have
achieved superior returns in numerous
countries over many decades (see chart).
But they are not wholly reliable. Some-
times the factors can underperform the
market for long periods. S&PDow Jones,
an index provider, monitors17 different fac-
tors. It found that only five beat the S&P
500, its main benchmark, last year.
Just as Molière’s Monsieur Jourdain
was amazed to learn he had been speaking
prose all his life without knowing it, any
one equity investor is exposed to these fac-
tors but may not know it. Research by
MSCI, another index provider, found that
more than half the performance of active
fund managers can be explained with ref-
erence to the most common factors.
“Smart beta” funds, which focus on one
or more factors, are subtly different from
conventional index funds that track a
benchmark. They hope to beat the market,
like active managers, but at lower cost.
These are dangerous waters. Fund manag-
ers have plenty of incentives to find anom-Trends in investmentMaxing the factors
The trillion-dollar search for a magic market-beating formulaFinance and economics
Also in this section60 Buttonwood: A weaker dollar
61 The American economy
61 Cancer investing
62 NAFTA and the car industry
63 A safe asset for the euro area
63 Private-equity megadeals
64 China’s formative central banker
65 Free exchange: Negative justiceThe why factorSource: Elroy Dimson, Paul Marsh and Mike Staunton,
“Factor-Based Investing: The Long-Term Evidence”,
Journal of Portfolio Management, 2017Factor investing, average annual premium from
investing in value stocks, selected countries
% per year
10 5 – 0 + 5 10 15
Ireland
Italy
United
States
Germany
BritainFrance
Sweden
Canada
Japan
ChinaWorld1975-2016 2000-16